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Chapter 11

Chapter 11. Measuring the Cost of Living. Outline. Construction of CPI Calculation of CPI and the Inflation Rate Problems in measuring CPI GDP Deflator versus CPI Correcting economic variables for the effects of inflation Indexation Real and Nominal interest rates. CPI.

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Chapter 11

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  1. Chapter 11 Measuring the Cost of Living

  2. Outline • Construction of CPI • Calculation of CPI and the Inflation Rate • Problems in measuring CPI • GDP Deflator versus CPI • Correcting economic variables for the effects of inflation • Indexation • Real and Nominal interest rates

  3. CPI • The Consumer Price Index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. • CPI measures changes in the cost of living over time. • CPI estimates by how much incomes must rise to maintain a constant standard of living. • CPI reflects the purchasing power of the currency • It reports the movement of prices with an index number.

  4. Calculating CPI: Various Steps • Fix the Basket: Identify the basket of goods consumed by a typical consumer • Find the Prices: Find the prices of each of the goods and services in the basket for each point in time • Compute the Basket’s Cost: Calculate the cost of the basket of goods and services at different times • Choose a base year and compute the index: Designate one year as the base year. CPI= (price of basket in current year/ price of basket in base year)x100

  5. Calculating CPI: Various Steps 5. Calculate the Inflation Rate: Use the CPI to calculate the inflation rate. • Inflation rate is the percentage change in the price index from the preceding period.

  6. What’s in the CPI’s Basket?

  7. CPI Monthly Index: Nov 2003

  8. Problems in Measuring The Cost of Living • The CPI is not a perfect measure of the “cost of living.” • Three reasons/problems: • Substitution Bias: Consumers substitute toward goods that have become relatively less expensive • Introduction of new goods: With greater variety consumers need fewer dollars to maintain any given standard of living • Unmeasured quality change: Quality impacts on the value of the currency

  9. The Consumer Price Index versus the GDP Deflator • The CPI: • includes only consumption goods • includes the cost of imports • is a fixed bundle of goods • The GDP Price Deflator: • includes all final goods and services • excludes imports • uses a current bundle of goods

  10. Correcting Economic Variables for the Effects of Inflation • To convert (inflate) past wages and prices into current terms: Current Year Dollars = Past Year Nominal Value X [(Price index in current year) ÷ (Price index in past year)]

  11. Correcting Economic Variables for the Effects of Inflation • To convert (deflate) current wages and prices into past year terms: Value in Past Year Dollars = Current Year Value X [(Price index in past year) ÷ (Price index in current year)]

  12. Indexation • Indexation is the automatic correction of a dollar amount for the effects of inflation by law or contract. E.g., COLA • Real interest rate= Nominal interest rate- Inflation rate

  13. Inflation in Canada: CPI inflation

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